Some of these principles are interrelated. I don’t like loopholes in part because of the reasons I just listed. But I also don’t like them because politicians often claim that they need to boost tax rates to make up for the fact that they lose revenue due to various deductions, credits, exemptions, and preferences.

And sometimes a deduction in the tax code even leads to bad policy by state and local government. Today, I want to discuss preferences in the internal revenue code for state and local taxes. And I’m motivated to address this issue because some of the politicians on Capitol Hill have pointed out an inequity, but they want to fix it in the wrong way.

Under current law, state and local income taxes are fully deductible, but state and local sales taxes are only temporarily deductible. The right policy is to get rid of any deductibility for any state and local tax. But since that would create a windfall of new tax revenue for the spendaholics in Washington, every penny of that revenue should be used to lower tax rates.

Not surprisingly, the crowd in Washington doesn’t take this approach. Instead, they want to extend deductibility for the sales tax. And they may even be amenable to raising other taxes to impose that policy.

More than five dozen House members are pressing leaders of a tax panel to preserve a deduction for state and local sales taxes. The bipartisan group of lawmakers say it would be unfair to voters in their states not to extend the sales tax deduction, given that taxpayers would still be able to deduct state and local income taxes. …Eight states in all — Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming — currently use a sales tax, but either don’t have or have a very limited state income tax. …The letter comes as many lawmakers hope to finish off an extenders package once Congress returns to Washington after November’s elections. Lawmakers will have to grapple with expiring Bush-era tax rates — just one part of the so-called fiscal cliff — when they return, and tax extenders could be tacked on to a broader package. The Senate Finance Committee has already passed an extenders package of its own, which included a two-year extension — at a cost of an estimated $4.4 billion over a decade — of the sales tax deduction.

I have some sympathy for these members of Congress. They represent states that have wisely decided not to impose income taxes, yet the federal tax system rewards profligate high-tax states such as New York and California with a permanent deduction for state and local income taxes.

This is a very misguided policy. It means that greedy politicians such as Governor Brown of California or Governor Cuomo of New York can raise tax rates and tell voters not to get too upset because they can deduct that additional burden. This means that a $1 tax hike results in a loss of take-home pay of as little as 65 cents.

This is what a fair tax code looks like

But you don’t cure one bad policy with another bad policy. A deduction for state and local sales taxes just augments the IRS-enforced preference for bigger government at the state and local level.

The right answer is the flat tax. Put in place the lowest-possible tax rate, which is feasible because all loopholes are wiped out.

In the case of state and local tax deductibility (or lack thereof, with any luck), that’s a win-win-win situation.

38 Responses

An entanglement of wealth re-allocation that is decided by politics rather than economics and markets, keeps demand for politician services, favors, power and fame high. Hence, distortions or no distortions politicians support it. When the core motivation is there, the excuses will be found as well as the rhetoric – and an eloquent one at that. The effort to put together some nice speeches (or hire people to compose them) in exchange for the power to allocate and reallocate trillions is indeed a very good investment, so long as the suckers keep consuming it while they march towards decline. The interesting thing is that it is the middle-high intelligence people, who fall for it the most, those loosely defined as the intellectuals.

In any case, nothing new here, the classic and well oiled, irreversible trip to decline as has been played in virtually every welfare state of Europe. The script moves on…

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